To initiate an arbitrage trade if the futures contract is overpriced, the trader
ID: 2790536 • Letter: T
Question
To initiate an arbitrage trade if the futures contract is overpriced, the trader should:
borrow at the risk-free rate, short the asset, and sell the futures.
short the asset, invest at the risk-free rate, and buy the futures.
short the future, invest at the risk-free rate, and buy the asset.
borrow at the risk-free rate, buy the asset, and sell the futures.
borrow at the risk-free rate, short the asset, and sell the futures.
B.short the asset, invest at the risk-free rate, and buy the futures.
C.short the future, invest at the risk-free rate, and buy the asset.
D.borrow at the risk-free rate, buy the asset, and sell the futures.
Explanation / Answer
D. Borrow at the risk-free rate, buy the asset, and sell the futures
Arbitrage gain araises when we sell in futures ( at over price) and invest in spot with risk free rate as the cost of funds. Technically, intrinsic value of the future = spot + Interest @ of risk free rate. When the actual future price is more than this intrinsic value, we can have an arbitrage gain by selling the futures and buying in the spot.